By Lawrence C. Phillips and Kay W. Tatum
In Brief
A ‘Kinder and Gentler’ IRS
In the aftermath of the IRS Restructuring and Reform Act of 1998, the agency has been systematically recreating itself with new policies and priorities. However, the substance and potential impact of many areas of the Internal Revenue Code (IRC) have changed little, if at all. IRS enforcement activity has by no means stopped. Although the audit rate has decreased, many practitioners are concerned that taxpayers, thinking that their chances of winning the “audit lottery” have improved, will find themselves mistaken.
The IRC still includes significant penalties for both taxpayers and preparers. The substance of the 1998 act requires the IRS to be less aggressive in ways that formerly were characterized as rigid and abusive. But both the IRC and self-regulatory guidelines for CPAs make it clear to tax practitioners that, although the enforcement environment may have changed, the ethical issues are as important as ever.
The IRS Restructuring and Reform Act of 1998 was intended to make the agency a “kinder and gentler” place. In the wake of Senate Finance Committee hearings that characterized the IRS as centralized, rigid, and abusive—and despite the amount of testimony at the hearings that was later discredited by the General Accounting Office, which found no evidence of systematic mistreatment of taxpayers—substantive tax law changes were enacted.
The act requires the IRS to terminate employees for certain proven violations, including—
Additionally, the act directs the IRS to develop performance measures that favor taxpayer service (user-friendly activities) and prohibits enforcement quotas. Since 1973, the IRS has had a written policy prohibiting production goals or quotas; the 1988 Taxpayer Bill of Rights also specifically prohibited the IRS from using production goals or quotas. However, in 1998 an IRS review panel revealed that both provisions were being violated in field-level collections and national IRS policy. (See “The IRS Restructuring and Reform Act of 1998,” The CPA Journal, January 1999.)
A Decline in IRS Enforcement Activity
Recent statistics indicate that IRS enforcement efforts have substantially diminished; this is partly attributable to IRS employees’ fears of dismissal due to the requirements of the 1998 act. In 1998 and 1999, for example, seizures of property by the IRS decreased by 98%, levies and garnishments declined by 75%, and the filing of liens decreased by 67%. In addition, IRS audit rates have been declining for both high-income individuals and major corporations. Among the largest U.S. corporations, the audit rate has declined from two-thirds in 1988 to slightly more than one-third in 1998. IRS audit rates for all corporations are expected to fall to 1% for 2000 (from approximately 3% in 1992). For individuals with gross income of $100,000 or more, fewer than one in 150 returns were expected to be audited in 2000, as opposed to one in 33 in 1992. Fewer than one in 300 tax returns of all individual taxpayers were expected to be audited last year, compared to one in 63 in 1981. Other factors contributing to a decline in IRS enforcement may have been static IRS budgets and the shift to a more user-oriented focus. For example, the IRS’s full-time staff has declined by 14% since 1995 and many auditors have been reassigned to routine customer service activities.
Reduced IRS enforcement because of risk-averse agents and declining audit rates may reward taxpayers that play the “audit lottery.” For example, taxpayers that are audited may receive overly lenient treatment: In 1999, the New York Times quoted one IRS agent as saying, “With this new law, if somebody says ‘I’m not paying,’ then we just say ‘thank you’ and leave.” Other agents indicated the possibility of favorable installment payment options or compromise settlements. Donald Alexander, a Washington, D.C., tax lawyer and former IRS commissioner, said that “taxpayers will be much more likely to play the audit lottery as enforcement drops and the IRS audit rates continue to decline.”
The 1998 tax law changes may also limit IRS audit discovery procedures and thereby provide added comfort for taxpayers that play the audit lottery. Under the 1998 act, so-called financial status or economic reality examination techniques will be limited to situations where the IRS has indications of unreported income, whereas previously IRS procedures broadly permitted agents to focus on a taxpayer’s lifestyle or standard of living.
Ethical Issues Facing Tax Practitioners
Many tax experts are concerned that reduced IRS enforcement may lead to widespread tax evasion. Despite the 1998 tax law changes mandating a stronger customer-service orientation, IRS Commissioner Charles Rossotti last year told a Senate subcommittee that a low audit rate eventually undermines the voluntary tax compliance system. Consequently, some changes may be forthcoming. The Clinton administration proposed a 9% increase for IRS activities in 2001 which, if implemented, would replace approximately one-sixth of the auditors the IRS has lost due to attrition since 1993.
Practicing CPAs have also expressed concern regarding ethical issues in tax practice. A survey of 1,000 AICPA Tax Division members considered the exploitation of the IRS audit selection process (playing the audit lottery) by clients to be a major ethical concern. Other major ethical issues that CPAs reported encountering included—
The AICPA Statements on Standards for Tax Services provide enforceable guidelines for tax practitioners regarding ethical issues and practice responsibilities (See “Statements on Standards for Tax Services: An Examination and Overview,” The CPA Journal, December 2000). Treasury Department Circular No. 230 provides similar prohibitions and accompanying sanctions, and tax preparer penalties might also apply under IRC section 6694.
Taxpayer Penalty Provisions
Although not all taxpayers playing the audit lottery are guilty of fraud, if a client suggests strategies that exploit the IRS audit selection process, CPAs should warn that both civil and criminal tax fraud penalties may be imposed under the IRC. Some tax positions have authoritative support or a realistic chance of being sustained if challenged. In other cases, the IRS may impose IRC section 6662 accuracy-related penalties instead of the fraud penalty.
IRC section 6663 imposes a 75% penalty for civil tax fraud, while section 7201 provides penalties for criminal tax fraud (up to $100,000 for individuals, $500,000 for corporations, and up to five years in jail). Taxpayers may be subject to other penalties, such as a 20% accuracy-related penalty under section 6662 for negligence, intentional disregard of rules or regulations, substantial understatement of tax, or valuation understatements. Generally, the tax law prevents the “stacking” of penalties (e.g., the 20% accuracy-related penalty is not imposed if the civil fraud penalty applies).
Fraud penalties do not apply if the taxpayer is merely negligent or ignorant of the tax law. The IRS must prove by clear and convincing evidence that the taxpayer engaged in intentional wrongdoing and with specific intent to avoid the tax owed. The burden of proof is higher for criminal fraud than for civil fraud: The court requires clear and convincing evidence of a civil fraud, which may be proved by the introduction of circumstantial evidence and reasonable inferences (e.g., the taxpayer failed to file tax returns, did not maintain adequate records, concealed assets, and failed to cooperate with the IRS). In a criminal case, the IRS must prove each element of a crime beyond a reasonable doubt.
IRC section 6001 requires that taxpayers maintain records of income and expenses adequate to permit an accurate determination of taxable income. Under IRC section 446(b), if the taxpayer does not uses a method that does not clearly reflect income, the IRS is empowered to reconstruct it. Thus, if the IRS uses a reconstruction approach such as the net worth method, the reconstructed income tax liability is presumed to be correct unless the taxpayer can show that the method was arbitrary, capricious, or erroneous.
Playing the Audit Lottery
The recent breakdown in IRS enforcement activity is likely to change taxpayer perceptions regarding taking aggressive tax positions and dampen their willingness to play the audit lottery. CPA tax practitioners may increasingly face an ethical dilemma in questionable situations (e.g., whether the client’s tax position has a realistic possibility of being sustained, administratively or judicially).
In appropriate circumstances, tax practitioners must inform their clients of tax penalty provisions, including both civil and criminal fraud. Although the prosecution of tax fraud has declined in recent years (i.e., from 1,190 tax fraud prosecutions in 1989 to only 766 in 1998), there are substantial potential adverse personal and financial consequences for businesses and their shareholders and employees.
Continued association with clients that adopt tax positions without merit or realistic possibility of being sustained may subject tax practitioners to sanctions under Treasury Circular No. 230 and preparer penalties under IRC section 6694, in addition to increased malpractice exposure. CPAs should continually evaluate their quality-control procedures as they relate to the acceptance of new clients and retention of existing clients.
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